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MONEY
WHAT IT IS
HOW IT WORKS
Banks play two distinct roles: They serve as depositories in the payment system, and they operate as financial intermediaries to seek profits through their own investments. Under the existing fractional reserve system, their lending creates new deposits without requiring an equal increase in bank reserves or bank capital. That leverage gives them enormous financial and political power which has often been misused. Far too much bank lending goes to support purely speculative activities which distort the financial markets, inflate asset prices, increase the fragility of the financial system, and serve no useful purpose in the real economy. A 100 Percent Reserve System These problems would be much less prevalent in a banking system in which deposits are required to be fully backed by reserves. In such a system, a bank could only lend the Fed funds it held in excess of the required reserves. It could not issue a loan by simply creating a new deposit for the borrower. Thus the ability of a bank to leverage its bets would end. Banks would focus on ordinary financial intermediation, borrowing at one rate and lending at a higher rate. The reserves acquired through new deposits would be fully encumbered, and offer no opportunity to create profitable investments. Banks would therefore have little incentive to acquire new deposits other than as a potential source of funds they could borrow to support their investments. In that case, why should banks continue to serve as depositories in a 100 percent reserve system? Surely there must be a more efficient system. Proposal for a Single National Depository Suppose the government established a National Bank to take over the depository role of private banks. It would accept deposits, execute payment orders, and provide cash in exchange for funds on deposit, but it would not lend or borrow money, or offer time deposits. All deposits would be transaction deposits and earn no interest, since they are the equivalent of cash. Payment orders would be executed by simply transferring funds between the accounts of depositors. Orders would be accepted by electronic means, e.g. plastic cards, the Internet, or the Fed wire. Paper checks would be phased out. Deposit insurance would be eliminated since all deposits are base money created by the Fed, on which there is no credit risk. With a single national depository, all accounts would be kept on one computer system. Verifying balances and making payments could be done in real time. Without a depository role, private banks would evolve into ordinary financial intermediaries which we will call financial service companies (FSCs). One should not confuse the twelve Federal Reserve Banks with the proposed National Bank. However the computer for the National Bank would be an extension of the Fed's computer system and record the individual deposit liabilities of the Fed itself. The Reserve Banks would provide the facilities and operate the National Bank. Local branches would be needed for cash withdrawals or deposits, most of which could be done through ATMs. Monetary Policy Implementation The National Bank would be the dollar-denominated depository for the U.S. Treasury as well as the entire private sector. Since the only money of direct concern to the economy is that held by the private sector, we define the money supply to exclude the deposits held by all government entities, including the Treasury and foreign central banks. Deposits in the National Bank would represent actual base money rather than claims on base money. Thus the concept of reserves loses its meaning. The Fed would implement monetary policy by managing the money market rate since the Fed funds interbank lending market would no longer exist. The money market rate could be defined as the average interest rate that major FSCs lend to each other on a short-term basis, say 30 days. Alternatively it could be the London Inter-Bank Offer Rate (LIBOR) on 30-day Eurodollar placements. When the interest rate in the money market rose above the target rate, the Fed would purchase securities in the open market to increase deposits in the National Bank. Conversely when the interest rate fell below the target rate, the Fed would sell securities from its own portfolio. In this way the Fed would continually adjust the supply of short-term loanable funds to meet the demand at its target rate. The Treasury would no longer hold Treasury Tax & Loan accounts in thousands of commercial banks, and continually transfer funds from them to replenish a Fed account, which would no longer exist. Rather the Treasury would spend out of its account in the National Bank, and deposit its receipts from taxes and bond sales in the same account. However it would still sell or redeem securities as needed to maintain an approximate balance between its inflows and outflows, as in the current system. That's necessary in order to avoid impacting the money supply, which would affect the Fed's ability to implement monetary policy. The Importance of Financial Service Companies FSCs pool the savings of investors and make them available to borrowers. They buy and sell financial instruments as diverse as bonds, mortgages, mutual fund shares, and insurance policies. FSCs today issue most of the credit on which the economy runs. In the proposed system, they would issue nearly all of it. Those seeking a return on their liquid assets have a variety of investment options. For example they could purchase money market mutual funds, Treasury bills, or make short term loans to FSCs. None of these are deposits and none are insured, although T-bills are free of credit risk. The two-tier system of bank-issued credit money backed by reserves of base money would no longer exist. The only type of money would be base money, all of which is created by the Fed. That means the Fed would have direct control of the aggregate money supply. As in the fractional reserve system, an FSC could lend but only by transferring funds from its own account to the borrower's account. An FSC in good standing could borrow from the Fed, just as private banks do now. The interest rate on Fed loans would be set 100 basis points above the money market target rate. With that large a spread, the lending facility would be used only for short term cash flow problems, and not as a source of funds to invest. The borrower would have to pledge Treasury securities as collateral. The loan could be rolled over indefinitely as long as the borrower had sufficient funds on deposit to pay the interest and to cover any change in the market value of the collateral. Minimizing Systemic Risk FSCs differ widely in the degree to which they mismatch the maturity of their assets and liabilities. Mismatching creates a potential cash flow problem. The main concern is a systemic failure in which a major default by one FSC could bring down many others due to the cascading of liabilities among them. A single depository system would not automatically end excessive risk-taking by FSCs. Therefore capital adequacy requirements should be imposed on all FSCs. For those designated as "too large to fail" because of the chaos such failure might create, the required ratio of capital to risk-adjusted assets should be an increasing function of the mismatch in their maturities. Government insurance should not be provided on the financial instruments offered by the FSCs. Bond rating agencies could rate the credit worthiness of FSCs as institutions. That would be of great value to investors, but more importantly FSCs would tend to avoid practices that reflect badly on their portfolios in the competitive business of lending for profit. Implementing the System Implementing such a system could not be done overnight. It would have to be carefully planned and phased in slowly enough to give all parties adequate time to make the necessary adjustments. A logical way to proceed would be to periodically increase the reserve ratio requirement on banks until it reached 100 percent. By that time, their interest-earning deposit liabilities should have been paid off, leaving only demand deposits fully backed by reserves. To acquire the funds to pay off their interest-earning deposits, banks would likely have to call loans and downsize their balance sheets. To provide sufficient money to meet the needs of the economy, the Fed would have to monetize additional debt by purchasing Treasury securities held by the public. Much of that would be done as a result of the Fed simply executing its monetary policy, that is by adjusting the money supply to meet the demand at its target interest rate. In transitioning to a single national depository, all demand deposits of banks and the reserves backing them would be transferred to the National Bank after 100% reserves had been achieved. Private banks would then become FSCs, or sell out to existing FSCs. Without the depository role, they would no longer need the same number of branch offices. The Fed would likely buy some of them in setting up its own depository branch offices. |
